Investors buy shares by investing their money up front. Margin trading is borrowing money from a broking house to purchase shares. It is a leveraging mechanism that enables investors to take exposure in the market over and above what is possible with their own resources.

Buying on margin

Let us assume that investor A has R1,00,000 in his bank account for the purpose of buying some shares. He can use this amount to buy 250 shares of company X at the rate of R400 each, excluding brokerage charges. In the normal course, he will pay for the shares on the settlement day to the exchange and receive 250 shares, which will be credited to his demat account.

Under margin trading, this money, i.e., R1,00,000 is used as margin and assuming that the margin rate is 25%, A can buy 1,000 share of company X.

As A does not have the money to take delivery of the 1,000 shares, he has to cover his purchase transaction by placing a sell order by end of the settlement cycle. Suppose the price of company X rises to R440 before the end of the settlement cycle, As profit is R40,000 (40*1000). But if the same thing happened with his investment by means of taking delivery of 250 shares, he could have made a profit of only R10,000 (40*250).

But, the risk is that if the price falls during the settlement cycle, A will still be forced to cover the transaction and the loss would be adjusted against his margin amount. For instance, by the end of the settlement cycle, if the price comes down to R380, then the loss will be R20,000 (20*1000).

Let us suppose A does not have shares in his demat account and he wants to sell X's shares as he expects the prices of share to go down. He can sell the shares and give the margin to his broker at the applicable rate. As he does not have the shares to deliver, he will have to cover his sell transaction by placing a buy order before the end of the settlement cycle. Just like buying on margin, in case the price moves in his favour (falls) he will make a profit. If the price goes up, he will make loss and it will be adjusted against the margin amount.

Maintenance margin

When an investor buys shares on margin, he must maintain a balanced ratio of margin debt to equity of at least 50% (which will vary depending on the broking house). If the debt portion exceeds the prescribed limit, the investor will be required to restore that ratio by depositing either more stock or cash into the brokerage account.

The facility of margin trading is available for Group 1 securities and those that are offered in the initial public offers and meet the conditions for inclusion in the derivatives segment of the stock exchanges.

Generally, buying on margin is good in a bull market. Of course, in a bear market, too, an investor can make profit if he is able to predict which share prices are going to come down. However, if one is new to investing and the stock market, it is advisable not to engage in margin trading.

* The writer is an associate professor in finance and accounting in IIM Shillong

Borrowing for a profit

* When an investor buys shares on margin, he must maintain a balanced ratio of margin debt to equity of at least 50% (which varies with broking houses)

* If the debt portion exceeds the prescribed limit, the investor will be required to restore that ratio by depositing either more stock or cash into the brokerage account

* The facility of margin trading is available for Group 1 securities and those that are offered in IPOs and meet the conditions for inclusion in the derivatives segment of the stock exchanges

* Generally, buying on margin is good in a bull market. In a bear market too, an investor can make profit if he is able to predict which share prices are going to come down